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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2003
[ ] Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the transition period from ____________ to _____________
Commission file number: 0-27622
HIGHLANDS BANKSHARES, INC.
(Exact Name of Registrant as Specified in its Charter)
Virginia 54-1796693
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
P.O. Box 1128
Abingdon, Virginia 24212-1128
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (276) 628-9181
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes __X__ No ____
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act.) Yes _____ No __X___
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.
2,657,036 shares of common stock, par value $1.25 per share,
outstanding as of November 9, 2003
Highlands Bankshares, Inc.
FORM 10-Q
For the Quarter Ended September 30, 2003
INDEX
PART I. FINANCIAL INFORMATION PAGE
Item 1. Financial Statements
Consolidated Balance Sheets
September 30, 2003 (Unaudited) and December 31, 2002 (Note 1). . . . 3
Consolidated Statements of Income (Unaudited)
for the Three Months and Nine Months Ended
September 30, 2003 and 2002 . . . . . . . . . . . . . . . . . . . . .4
..
Consolidated Statements of Cash Flows (Unaudited)
for the Nine Months Ended
September 30, 2003 and 2002 . . . . . . . . . . . . . . . . . . . . .5
Consolidated Statements of Changes in
Stockholders' Equity (Unaudited) for the Three Months and
Nine Months Ended September 30, 2003 and 2002 . . . . . . . .. . 6-7
Notes to Consolidated Financial Statements (Unaudited) . . . . . . . . . 8-12
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of
Operations . . . . . . . . . . . . . . . . . . . . . . . . . .13-16
Item 3. Quantitative and Qualitative Disclosures About Market Risk . . . . 17-18
Item 4. Controls and Procedures . . . . . . . . . . . . . . . . . . . . .17-18
PART II. OTHER INFORMATION
Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . .19
Item 2. Changes in Securities and Use of Proceeds . . . . . . . . . . . . . .19
Item 3. Defaults Upon Senior Securities . . . . . . . . . . . . . . . . . . .19
Item 4. Submission of Matters to a Vote of
Security Holders . . . . . . . . . . . . . . . . . . . . . . . .19
Item 5. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . .19
Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . . . 19
SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-29
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Consolidated Balance Sheets
(Amounts in thousands)
(Unaudited) (Note 1)
ASSETS September 30, 2003 December 31, 2002
------------------ -----------------
Cash and due from banks $ 12,206 $ 13,369
Federal funds sold 12,781 5,132
------------ ---------
Total Cash and Cash Equivalents 24,987 18,501
------------ ---------
Investment securities available for sale (amortized
cost $111,328 as of September 30, 2003, $101,211 as of
December 31, 2002) 110,845 102,743
Other investments, at cost 2,368 2,182
Loans, net of allowance for loan losses of $4,183 at
September 30, 2003, $3,877 at December 31, 2002 364,345 335,644
Premises and equipment, net 14,744 13,157
Interest receivable 2,897 2,708
Other assets 12,110 10,668
------------ ---------
Total Assets $ 532,296 $ 485,603
============ =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Deposits:
Non-interest bearing $ 63,765 $ 55,597
Interest bearing 392,342 354,704
------------ ---------
Total Deposits 456,107 410,301
------------ ---------
Interest, taxes and other liabilities 2,348 2,309
Other short-term borrowings 17,000 19,094
Long-term debt 16,434 14,200
Capital securities 6,300 7,500
------------ ---------
Total Other Liabilities 42,082 43,103
------------ ---------
Total Liabilities 498,189 453,404
------------ ---------
STOCKHOLDERS' EQUITY
Common stock (2,656 and 2,648 shares issued and
outstanding, respectively) 3,320 3,309
Additional paid-in capital 6,258 6,150
Retained earnings 24,848 21,729
Accumulated other comprehensive income (319) 1,011
------------ ---------
Total Stockholders' Equity 34,107 32,199
------------ ---------
Total Liabilities and Stockholders' Equity $ 532,296 $ 485,603
============ =========
See accompanying Notes to Consolidated Financial Statements
3
Consolidated Statements of Income
(Amounts in thousands, except for per share data)
(Unaudited)
Three Months Ended Three Months Ended Nine Months Ended Nine Months Ended
September 30, 2003 September 30, 2002 September 30, 2003 September 30, 2002
------------------ ------------------ ------------------ ------------------
INTEREST INCOME
Loans receivable and fees on loans $ 6,260 $ 6,510 $18,686 $19,669
Securities available for sale:
Taxable 497 717 1,813 2,487
Exempt from taxable income 577 446 1,488 1,042
Other investment income 25 30 81 86
Federal funds sold 12 32 63 68
------- ------- ------- -------
Total Interest Income 7,371 7,735 22,131 23,352
------- ------- ------- -------
INTEREST EXPENSE
Deposits 2,564 2,889 7,896 8,974
Federal funds purchased - - - 3
Other borrowed funds 625 634 1,909 1,836
------- ------- ------- -------
Total Interest Expense 3,189 3,523 9,805 10,813
------- ------- ------- -------
Net Interest Income 4,182 4,212 12,326 12,539
------- ------- ------- -------
Allowance for Loan Losses 447 387 1,427 1,374
------- ------- ------- -------
Net Interest Income after Allowance for
Loan Losses 3,735 3,825 10,899 11,165
------- ------- ------- -------
NON-INTEREST INCOME
Securities gains (losses), net 3 14 385 17
Service charges on deposit accounts 664 709 1,948 1,899
Other service charges, commissions and fees 212 148 595 484
Other operating income 165 196 469 244
------- ------- ------- -------
Total Non-Interest Income 1,044 1,067 3,397 2,644
------- ------- ------- -------
NON-INTEREST EXPENSE
Salaries and employee benefits 1,937 1,767 5,690 5,335
Occupancy expense of bank premises 154 148 446 440
Furniture and equipment expense 385 491 1,221 1,337
Other operating expense 913 1,012 2,605 2,600
------- ------- ------- -------
Total Non-Interest Expense 3,389 3,418 9,962 9,712
------- ------- ------- -------
Income Before Income Taxes 1,390 1,474 4,334 4,097
Income Tax Expense 274 362 950 1,065
------- ------- ------- -------
Net Income $ 1,116 $ 1,112 $ 3,384 $ 3,032
======= ======= ========= =======
Basic Earnings Per Common Share - Weighted
Average $ 0.42 $ 0.42 $ 1.28 $ 1.15
======= ======= ========= =======
Earnings Per Common Share - Assuming Dilution $ 0.40 $ 0.40 $ 1.20 $ 1.09
======= ======= ========= =======
See accompanying Notes to Consolidated Financial Statements
4
Consolidated Statements of Cash Flows
(Amounts in thousands)
(Unaudited)
Nine Months Ended Nine Months Ended
September 30, 2003 September 30, 2002
------------------ ------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 3,384 $ 3,032
Adjustments to reconcile net income to net cash provided by operating
activities
Provision for loan losses 1,427 1,374
Depreciation and amortization 707 760
Net realized gains on available-for-sale securities (385) (17)
Net amortization on securities 195 118
Amortization of capital issue costs 9 8
(Increase) decrease in interest receivable (189) 51
Increase in other assets (783) (7,906)
Increase (decrease) in interest, taxes and other liabilities 39 (588)
-------- --------
Net cash provided by (used in) operating activities 4,404 (3,168)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of debt and equity securities 5,805 9,394
Proceeds from maturities of debt and equity securities 20,087 16,144
Purchase of debt and equity securities (35,817) (26,926)
Purchase of other investments (186) (211)
Net increase in loans (30,128) (11,022)
Premises and equipment expenditures (2,279) (702)
-------- --------
Net cash used in investing activities (42,518) (13,323)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in time deposits 14,626 (11,859)
Net increase in demand, savings and time deposits 31,180 25,920
Net increase (decrease) in short-term borrowings (2,094) 6,142
Net increase in long-term debt 2,234 3,752
Cash dividends paid (265) (238)
Repurchase of capital securities (1,200) -
Proceeds from exercise of common stock options 103 84
Proceeds from issuance of common stock through Dividend Reinvestment and
Stock Purchase Plan 16 -
-------- --------
Net cash provided by financing activities 44,600 23,801
-------- --------
Net increase in cash and cash equivalents 6,486 7,310
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 18,501 12,241
-------- --------
CASH AND CASH EQUIVALENTS AT END OF QUARTER $ 24,987 $ 19,551
========= ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the year
for:
Interest $ 9,864 $ 11,628
========= ========
Income taxes $ 1,050 $ 1,096
========= ========
See accompanying Notes to Consolidated Financial Statements
5
See accompanying Notes to Consolidated Financial Statements
Consolidated Statements of Changes in Stockholders' Equity
(Amounts in thousands)
(Unaudited)
Accumulated
Common Stock Additional Other Total
------------ Paid-in Retained Comprehensive Stockholders'
Shares Par Value Capital Earnings Income Equity
------ --------- ------- -------- ------ ------
Balance June 30, 2002 2,645 $ 3,306 $ 6,088 $ 19,545 $ 594 $ 29,533
Comprehensive income:
Net income - - - 1,112 - 1,112
Change in unrealized gain (loss) on
securities available for sale, net of
deferred income tax expense of $334 - - - - 649 649
Less: reclassification adjustment - - - - (10) (10)
net of deferred tax expense of $4 ------- ---------
Total comprehensive income - - - - - 1,751
---------
Common stock issued for stock options
exercised, net 2 3 54 - - 57
Common stock issued for dividend
reinvestment and optional cash
purchase plan - - - - - -
Cash dividend - - - - - -
----- ------- ------- -------- ------- --------
Balance, September 30, 2002 2,647 $ 3,309 $ 6,142 $ 20,657 $ 1,233 $ 31,341
===== ======= ======= ======== ======= ========
Balance, June 30, 2003 2,654 $ 3,317 $ 6,226 $ 23,732 $1,404 $ 34,679
Comprehensive income:
Net income - - - 1,116 - 1,116
Change in unrealized gain (loss) on
securities available for sale, net of
deferred income tax benefit of
$887 - - - (1,721) (1,721)
Less: reclassification adjustment - - - (2) (2)
net of deferred tax expense of $1 -------- ---------
Total comprehensive income - - - - - (607)
Common stock issued for stock options
exercised, net 2 3 32 - - 35
Common stock issued for dividend
reinvestment and optional cash
purchase plan - - - - - -
Cash dividend - - - - - -
Balance, September 30, 2003 2,656 $ 3,320 $ 6,258 $ 24,848 $ (319) $ 34,107
===== ======= ======= ======== ======== ========
See accompanying Notes to Consolidated Financial Statements
(continued)
6
Consolidated Statements of Changes in Stockholders' Equity (continued)
(Amounts in thousands)
(Unaudited)
Accumulated
Common Stock Additional Other Total
------------ Paid-in Retained Comprehensive Stockholders'
Shares Par Value Capital Earnings Income Equity
------ --------- ------- -------- ------ ------
Balance December 31, 2001 2,644 $ 3,304 $ 6,063 $ 17,863 $ 222 $ 27,452
Comprehensive income:
Net income - - - 3,032 - 3,032
Change in unrealized gain (loss) on
securities available for sale, net of
deferred income tax expense of $521 - - - - 1,023 1,023
Less: reclassification adjustment - - - - (12) (12)
net of deferred tax expense of $5 ------- --------
Total comprehensive income - - - - - $ 4,043
--------
Common stock issued for stock options
exercised, net 2 4 66 - - 70
Common stock issued for dividend
reinvestment and optional cash
purchase plan 1 1 13 - - 14
Cash dividend - - - (238) - (238)
----- ------- ------- -------- ------- --------
Balance, September 30, 2002 2,647 $ 3,309 $ 6,142 $ 20,657 $ 1,233 $ 31,341
===== ======= ======= ======== ======= ========
Balance, December 31, 2002 2,648 $ 3,309 $ 6,150 $ 21,729 $ 1,011 $ 32,199
Comprehensive income:
Net income - - - 3,384 - 3,384
Change in unrealized gain (loss) on
securities available for sale, net of
deferred income tax benefit of
$554 - - - (1,076) (1,076)
Less: reclassification adjustment - - - (254) (254)
net of deferred tax expense of $131 ------- --------
Total comprehensive income - - - - - 2,054
--------
Common stock issued for stock options
exercised, net 7 10 93 - - 103
Common stock issued for dividend
reinvestment and optional cash
purchase plan 1 1 15 - - 16
Cash dividend - - - (265) - (265)
----- ------- ------- -------- ------- --------
Balance, September 30, 2003 2,656 $ 3,320 $ 6,258 $ 24,848 $ (319) $ 34,107
===== ======= ======= ======== ======= ========
See accompanying Notes to Consolidated Financial Statements
7
Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)
Note 1. - General
The consolidated financial statements of Highlands Bankshares, Inc. (the
"Company") conform to United States generally accepted accounting principles and
to industry practices. The accompanying consolidated financial statements are
unaudited. In the opinion of management, all adjustments necessary for a fair
presentation of the consolidated financial statements have been included. All
such adjustments are of a normal and recurring nature. The consolidated balance
sheet as of December 31, 2002 has been extracted from the audited financial
statements included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2002 (the "2002 Form 10-K"). The notes included herein should
be read in conjunction with the notes to consolidated financial statements
included in the 2002 Form 10-K. The results of operations for the three-month
and nine-month periods ended September 30, 2003 and 2002 are not necessarily
indicative of the results to be expected for the full year.
Note 2. - Allowance for Loan Losses
A summary of transactions in the consolidated allowance for loan losses for the
nine months ended September 30, is as follows:
2003 2002
---- ----
Balance, January 1 $ 3,877 $ 3,418
Provision 1,427 1,374
Recoveries 80 123
Charge-offs (1,201) (1,077)
------- -------
Balance, September 30 $ 4,183 $ 3,838
======= =======
Note 3. - Income Taxes
Income tax expense for the nine months ended September 30 is different than the
amount computed by applying the statutory corporate federal income tax rate of
34% to income before taxes. The reasons for these differences are as follows:
2003 2002
---- ----
Tax expense at statutory rate $ 1,474 $ 1,393
Increase (reduction) in taxes from:
Tax-exempt interest (506) (314)
Other, net (18) (14)
---- ----
Provision for income taxes $ 950 $ 1,065
======= =======
8
Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)
Note 4. - Capital Requirements
Regulators of the Company and its subsidiaries, including Highlands Union Bank
(the "Bank"), have implemented risk-based capital guidelines which require the
maintenance of certain minimum capital as a percent of assets and certain
off-balance sheet items adjusted for predefined credit risk factors. The
regulatory minimum for Tier 1 and combined Tier 1 and Tier 2 capital ratios are
4.0% and 8.0%, respectively. Tier 1 capital includes tangible equity reduced by
goodwill and certain other intangibles. Tier 2 capital includes portions of the
allowance for loan losses, not to exceed Tier 1 capital. In addition to the
risk-based guidelines, a minimum leverage ratio (Tier 1 capital as a percentage
of average total consolidated assets) of 4.0% is required. This minimum may be
increased by at least 1.0% or 2.0% for entities with higher levels of risk or
that are experiencing or anticipating significant growth. The following table
contains the capital ratios for the Company and the Bank as of September 30,
2003.
Entity Tier 1 Combined Capital Leverage
------ ------ ---------------- --------
Highlands Bankshares, Inc. 11.48% 12.68% 7.63%
Highlands Union Bank 9.94% 11.14% 6.62%
Note 5 - Capital Securities
The Company completed a $7.5 million capital issue of trust preferred debt
securities on January 23, 1998. These securities were issued by Highlands
Capital Trust, a wholly owned subsidiary of the Company, at a price per share of
$25.00. These securities were issued at a 9.25% fixed rate with a 30 year term
and a 10 year call provision at the Company's discretion. This capital was
raised to meet current and future opportunities of the Company. During the first
quarter of 2003, the Company received regulatory approval to re-purchase 48,000
shares or 16% of these securities. The shares were repurchased in April 2003 at
a price of $26.15 per share which is equal to the 2008 call price. For future
regulatory capital purposes, this $1.2 million par value of these repurchased
trust preferred securities will not be eligible to be included in Tier 1 or Tier
2 capital of the Company.
Note 6 - Earnings Per Share
The following table contains information regarding the Company's computation of
basic earnings per share and diluted earnings per share for the nine months
ended September 30, 2003 and 2002.
Basic EPS Number of Shares Diluted EPS Number of Shares
--------- ---------------- ----------- ----------------
Year to Date
September 30, 2003 $ 1.28 2,652,321 $ 1.20 2,808,932
September 30, 2002 $ 1.15 2,644,500 $ 1.09 2,779,621
Quarter to Date
September 30, 2003 $ 0.42 2,654,697 $ 0.40 2,811,308
September 30, 2002 $ 0.42 2,645,565 $ 0.40 2,780,666
9
Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)
Note 7 - Dividend Reinvestment and Stock Purchase Plan
On March 1, 2002 the Company initiated a Dividend Reinvestment and Stock
Purchase Plan (the "Plan") for its shareholders. The Plan enables shareholders
to reinvest their cash dividends to purchase additional shares of the Company's
common stock. Shareholders also have the option to make additional cash
purchases of stock ranging from $100 to $5,000 per quarter. Shares in the Plan,
which covers 50,000 shares of common stock, are purchased in the open market or
directly from the Company. As of October 31, 2003, the Plan has received $232
thousand in reinvested dividends and optional cash purchases from Plan
participants for the 2003 calendar year. The Plan has been widely accepted by
the shareholder base.
Note 8 - Commitments and Contingencies
The Bank is a party to various financial instruments with off-balance sheet risk
arising in the normal course of business to meet the financing needs of its
customers. Those financial instruments include commitments to extend credit and
standby letters of credit. Those commitments include: standby letters of credit
of approximately $2.97 million; equity lines of credit of $6.24 million; credit
card lines of credit of $3.51 million; commercial real estate, construction and
land development commitments of $1.01 million; and other unused commitments to
fund loans of $18.18 million.
The Bank has completed the construction of a branch office in Blountville,
Tennessee. This branch office opened September 1, 2003 as a full service branch.
The purchase of this property was completed by a cash payment of $315 thousand
and the swap of a Bank owned piece of property valued at $300 thousand for a
total cost of $615 thousand.
As of September 30, 2003, the Bank had closed on the purchase of a piece of
property in Banner Elk, North Carolina for use as a future branch office site.
The closing on this piece of property was finalized on August 4, 2003 at a
purchase price of approximately $520 thousand. The Bank has completed the bid
process for the construction of this branch office and site preparation is
underway as of September 30, 2003. Regulatory approvals to open this branch
office were received during the second quarter of 2003. This branch office is
expected to open in late 2003 or early 2004. The estimated total cost of the
project is $1.3 million.
The Bank has completed the expansion of its branch office in West Abingdon from
an express facility to a full service location. The construction was completed
and the branch reopened on July 28, 2003 as a full service facility with
approximately 2800 square feet being added.
Note 9 - Summary of Significant Accounting Policy Update For Certain Required
Disclosures
The Company has a stock option plan for certain executives and directors
accounted for under the intrinsic value method in accordance with Accounting
Principles Board ("APB") 25. Because the exercise price of the Company's
employee / director stock options equals the market price of the underlying
stock on the date of grant, no compensation expense is recognized. The effect of
option shares on earnings per share relates to the dilutive effect of the
underlying options outstanding. To the extent the granted exercise share price
is less than the current market price (i.e., "in the money"), there is an
economic incentive for the shares to be exercised and an increase in the
dilutive effect on earnings per share.
10
Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)
In December 2002, the Financial Accounting Standards Board (the "FASB") issued
FAS 148, "Accounting for Stock-Based Compensation." This new standard provides
alternative methods of transition for a voluntary change to the fair value
method of accounting for stock-based compensation. In addition, the Statement
amends the disclosure requirements of FAS 123 to require prominent disclosure in
both annual and interim financial statements about the method of accounting for
stock-based compensation and the underlying effect of the method used on
reported results until exercised.
Assuming use of the fair value method of accounting for stock options, pro forma
net income and earnings per share for the three and nine month periods ended
September 30, 2003 and 2002 would have been estimated as follows:
Nine Months Ended Nine Months Ended Three Months Ended Three Months Ended
September 30, 2003 September 30, 2002 September 30, 2003 September 30, 2002
------------------ ------------------ ------------------ ------------------
(Amounts in thousands, except per share data)
Net income as reported $ 3,384 $ 3,032 $ 1,116 $ 1,112
Less: Total stock based
employee compensation expense
determined under fair value
method for all awards, net of
related tax effects (208) (199) (208) (199)
------- ------- ------ ------
Pro forma net income $ 3,176 $ 2,833 $ 908 $ 913
======= ======= ====== ======
Earnings per share:
Basic as reported $ 1.28 $ 1.15 $ 0.42 $ 0.42
Basic pro forma $ 1.20 $ 1.07 $ 0.34 $ 0.34
Diluted as reported $ 1.20 $ 1.09 $ 0.40 $ 0.40
Diluted pro forma $ 1.13 $ 1.02 $ 0.32 $ 0.33
In November 2002, the FASB issued Interpretation No. 45 (FIN 45), "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others." This interpretation expands the
disclosures to be made by a guarantor in its financial statements about its
obligations under certain guarantees and requires the guarantor to recognize a
liability for the fair value of an obligation assumed under a guarantee. FIN 45
clarifies the requirements of FAS 5, "Accounting for Contingencies", relating to
guarantees. In general, FIN 45 applies to contracts or indemnification
agreements that contingently require the guarantor to make payments to the
guaranteed party based on changes in an underlying value that is related to an
asset, liability, or equity security of the guaranteed party. Certain guarantee
contracts are excluded from both the disclosure and recognition requirements of
this interpretation, including, among others, guarantees relating to employee
compensation, residual value guarantees under capital lease arrangements,
commercial letters of credit, loan commitments, subordinated interests in a
special purpose entity, and guarantees of a company's own future performance.
11
Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)
Other guarantees are subject to the disclosure requirements of FIN 45 but not to
the recognition provisions and include, among others, a guarantee accounted for
as a derivative instrument under FAS 133, a parent's guarantee of debt owed to a
third party by its subsidiary or vice versa, and a guarantee which is based on
performance rather than price. FIN 45 requires disclosure of the nature of the
guarantee, the maximum potential amount of future payments that the guarantor
could be required to make under the guarantee, and the current amount of the
liability, if any, for the guarantor's obligations under the guarantee. The
requirements of FIN 45 did not have a material impact on results of operations,
financial position, or liquidity in the first nine months of 2003.
12
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis is provided to address information about
the Company's financial condition and results of operations that is not
otherwise apparent from the consolidated financial statements incorporated by
reference or included in this report. Reference should be made to those
statements for an understanding of the following discussion and analysis.
Critical Accounting Policies
The financial condition and results of operations presented in the Consolidated
Financial Statements, accompanying Notes to the Consolidated Financial
Statements and management's discussion and analysis are, to a large degree,
dependent upon the accounting policies of Highlands Bankshares, Inc. (the
"Company"). The selection and application of these accounting policies involve
judgments, estimates, and uncertainties that are susceptible to change.
Presented below is discussion of those accounting policies that management
believes are the most important to the portrayal and understanding of the
Company's financial condition and results of operations. These critical
accounting policies require management's most difficult, subjective and complex
judgments about matters that are inherently uncertain. In the event that
different assumptions or conditions were to prevail, and depending upon the
severity of such changes, the possibility of materially different financial
condition or results of operations is a reasonable likelihood. See also Note 1
of the Notes to Consolidated Financial Statements in the Company's Annual Report
on Form 10-K for the year ended December 31, 2002.
Allowance for Loan Losses
The Company monitors and maintains an allowance for loan losses to absorb an
estimate of probable losses inherent in the loan and lease portfolio. The
Company maintains policies and procedures that address the systems of controls
over the following areas of maintenance of the allowance: the systematic
methodology used to determine the appropriate level of the allowance to provide
assurance they are maintained in accordance with accounting principles generally
accepted in the United States of America; the accounting policies for loan
charge-offs and recoveries; the assessment and measurement of impairment in the
loan portfolio; and the loan grading system.
The Company evaluates various loans individually for impairment as required by
Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by
Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors
for Impairment of a Loan - Income Recognition and Disclosures. Loans evaluated
individually for impairment include non-performing loans, such as loans on
non-accrual, loans past due by 90 days or more, restructured loans and other
loans selected by management. The evaluations are based upon discounted expected
cash flows or collateral valuations. If the evaluation shows that a loan is
individually impaired, then a specific reserve is established for the amount of
impairment. If a loan evaluated individually is not impaired, then the loan is
assessed for impairment under SFAS No. 5, Accounting for Contingencies, with a
group of loans that have similar characteristics.
For loans without individual measures of impairment, the Company makes estimates
of losses for groups of loans as required by SFAS No. 5. Loans are grouped by
similar characteristics, including the type of loan, the assigned loan grade and
the general collateral type. A loss rate reflecting the expected loss inherent
in a group of loans is derived based upon estimates of default rates for a given
loan grade, the predominant collateral type for the group and the terms of the
loan. The resulting estimate of losses for groups of loans are adjusted for
relevant environmental factors and other conditions of the portfolio of loans
and leases, including: borrower and industry concentrations; levels and trends
in delinquencies, charge-offs and recoveries; changes in underwriting standards
and risk selection; level of experience, ability and depth of lending
management; and national and local economic conditions.
13
The amount of estimated impairment for individually evaluated loans and groups
of loans is added together for a total estimate of loans and lease losses. This
estimate of losses is compared to the allowance for loan and lease losses of the
Company as of the evaluation date and, if the estimate of losses is greater than
the allowance, an additional provision to the allowance would be made. If the
estimate of losses is less than the allowance, the degree to which the allowance
exceeds the estimate is evaluated to determine whether the allowance falls
outside a range of estimates. If the estimate of losses is below the range of
reasonable estimates, the allowance would be reduced by way of a credit to the
provision for loan losses. The Company recognizes the inherent imprecision in
estimates of losses due to various uncertainties and variability related to the
factors used, and therefore a reasonable range around the estimate of losses is
derived and used to ascertain whether the allowance is too high. If different
assumptions or conditions were to prevail and it is determined that the
allowance is not adequate to absorb the new estimate of probable losses, an
additional provision for loan losses would be made, which amount may be material
to the Consolidated Financial Statements.
Intangibles and Goodwill
The Company had approximately $569 thousand in intangible assets and goodwill at
September 30, 2003. Capital issue costs relating to the January 21, 1998
issuance of junior subordinated debt securities are stated a cost less
accumulated amortization. Amortization is computed on the straight-line method
over the life of the securities - 30 years. On September 23, 2000, the Company
acquired a branch office of First Vantage Bank in Rogersville, TN and paid an
applicable deposit premium. The premium was recorded as Goodwill and is stated
at cost less accumulated amortization. Amortization is computed on the
straight-line method over 15 years.
SFAS No. 142 requires that goodwill be tested annually using a two-step process.
The first step is to identify a potential impairment. The second step measures
the amount of the impairment loss, if any. Processes and procedures have been
identified for the two-step process.
When the Company completes its ongoing review of the recoverability of
intangible assets and goodwill, factors that are considered important to
determining whether an impairment might exist include loss of customers acquired
or significant withdrawals of the liabilities currently under management.
Results of Operations
Results of operations for the three-month and nine-month periods ended September
30, 2003 reflected net income of $1.12 million and $3.38 million, respectively,
an increase of 0.36% and 11.61% over the corresponding periods in 2002. This
increase was in part due to the Bank's ability to maintain a net interest margin
that approximated the prior year as well as continued increases in non-interest
income, including gains on securities sold. During the last two years, the Bank
has been in a liability sensitive position. Over this time period, the Bank's
interest-bearing liabilities have been repricing at a quicker pace than its
interest-earning assets as interest rates have fallen. This trend has slowed
over the past six months. Total interest income for the nine months ended
September 30, 2003 was approximately $1.2 million less than the comparable 2002
period due to new loan and investment securities volume being recorded at lower
rates and existing adjustable rate loans and investment securities repricing
down to lower rates. The Company's total interest expense has decreased by
approximately $1.1 million due to new interest-bearing deposits being recorded
at lower rates and existing interest-bearing deposits repricing lower as they
mature or reprice. However, during the first nine months of 2003, the Bank also
increased its non-interest income by $753 thousand over the corresponding period
for 2002. This increase was primarily due to increased non-sufficient funds
income, earnings related to Bank-Owned Life Insurance, earnings related to its
equity ownership in Virginia Title Center, LLC, security gains, and increased
merchant and debit card fee income. Operating results of the Company when
measured as a percentage of average equity reveals a decrease in return on
average equity from 13.91% for the nine-month period ended September 30, 2002 to
13.33% for the corresponding period in 2003.
14
Return on average assets of 0.88% for the nine months ended September 30, 2003
reflects an increase of 1.15% over return on average assets of 0.87% for the
comparable 2002 period.
Net interest income for the three-month and nine-month periods ended September
30, 2003 decreased 0.71% and 1.70%, respectively, or approximately $30 thousand
and $213 thousand as compared to the corresponding 2002 periods. Average
interest-earning assets increased approximately $52.42 million from the period
ended September 30, 2002 to the current period while average interest-bearing
liabilities increased $43.50 million from the same period. The tax-equivalent
yield on average interest-earning assets was 6.15% in 2003 representing a
decrease of 111 basis points over the yield of 7.26% in 2002. The yield on
average interest-bearing liabilities decreased 73 basis points to 3.14% in 2003
as compared to 3.87% in 2002.
The provisions for possible loan losses for the three-month and nine-month
periods ended September 30, 2003 totaled $447 thousand and $1.43 million,
respectively, a $60 thousand and $53 thousand increase from the corresponding
periods in 2002. The Company continually monitors the loan portfolio for signs
of credit weaknesses or developing collection problems. Loan loss provisions for
each period are determined after evaluating the loan portfolio and determining
the level necessary to absorb current charge-offs and maintain the reserve at
adequate levels. Net charge-offs for the first nine months of 2003 were $1.12
million compared with $954 thousand for the corresponding period in 2002.
Year-to-date net charge-offs were 0.30% and 0.28% of total loans for the periods
ended September 30, 2003 and September 30, 2002. Loan loss reserves increased
8.99% to $4.18 million at September 30, 2003 from the same date in 2002. The
Company's allowance for loan loss reserves at September 30, 2003, September 30,
2002 and December 31, 2002 has remained level at 1.14% of total loans.
Financial Position
Total loans have increased from $335.53 million at September 30, 2002 to $368.53
million at September 30, 2003. For the nine-month period ended September 30,
2003, total loans have increased $29.01 million. The loan to deposit ratio has
decreased from 82.61% at September 30, 2002 to 80.80% at September 30, 2003. The
loan to deposit ratio at December 31, 2002 was 82.75%. The main reason for the
decrease in the loan to deposit ratio is due to a significant increase in
customer deposits due to the volatility in the equity markets. Investor
confidence seems to still be very low, and it appears that individual investors
are placing their money in more stable and liquid investments such as interest
checking, savings and time deposit accounts. Deposits as of September 30, 2003
have increased $45.81 million since December 31, 2002 and $49.95 million since
September 30, 2002. Consumers have continued to invest their monies primarily in
savings and checking accounts due to the continued market uncertainty. Likewise,
with the less favorable economic environment, customers are not borrowing money
as readily as they have in past years. The majority of the Company's loan growth
for the first nine months of 2003 has primarily been in real estate secured
loans. This group of loans has grown $29.23 million or 12.39% from December 31,
2002. Loan demand continues at a moderate pace even during a period of economic
uncertainty and within a competitive market area.
Non-performing assets are comprised of loans on non-accrual status, loans
contractually past due 90 days or more and still accruing interest, other real
estate owned and repossessions. Non-performing assets were $6.46 million or
1.75% of total loans at September 30, 2003 compared with $3.11 million or 0.92%
of total loans at December 31, 2002 and $3.06 million or 0.91% of total loans at
September 30, 2002. This increase in non-performing assets at September 30, 2003
can be attributed in large part to less favorable economic conditions within the
Company's primary market areas as well as several large commercial loans that
have gone past due greater than ninety days. The downturn in the economy has
resulted in a number of plant layoffs and downsizings that have contributed to
this increase in non-performing assets.
Investment securities and other investments totaled approximately $113.21
million (market value) at September 30, 2003, which reflects an increase of
$8.29 million or 7.90% from the December 31, 2002
15
total of $104.92 million. The majority of the Company's investment purchases
during the nine-month period were tax-exempt municipals and adjustable rate
mortgage-backed securities. Investment securities available for sale and other
investments, as of September 30, 2003 are comprised of mortgage backed
securities (approximately 43.10% of the total securities portfolio), municipal
issues (approximately 40.15%), collateralized mortgage obligations (CMO's)
(approximately 0.50%), corporate bonds (approximately 3.28%), SBA backed
securities and asset-backed securities (approximately 1.22%), U. S. government
agencies (approximately 0.44%), and equity securities (approximately 9.67%). The
Company's entire securities portfolio is classified as available for sale at
both September 30, 2003 and 2002. Other investments include the Bank's holdings
of Federal Reserve, Federal Home Loan Bank and Community Bankers Bank stock.
These investments (carrying value of $2.37 million and approximately 2.09% of
the total) are considered to be restricted as the Company is required to hold
these investments and the only market for these investments is the issuing
agency.
In June 2002, the Bank purchased $7.00 million of Bank-Owned Life Insurance
covering the lives of selected officers as well as the Directors of the Bank.
The monthly earnings related to the insurance policies will be used to offset
future employee benefit costs. An additional $380 thousand of BOLI was purchased
during the third quarter of 2002.
In April 2002, the Bank became an equity owner in the Virginia Title Center,
LLC, headquartered in Roanoke, Virginia. Virginia Title Center, LLC was formed
for the purpose of issuing title insurance and is owned by several Virginia
banks. It is anticipated that this investment will generate on-going
non-interest income for the Bank.
Liquidity and Capital Resources
Total stockholders' equity of the Company was $34.11 million at September 30,
2003, representing an increase of $2.77 million or 8.83% over September 30,
2002. Total stockholders' equity at December 31, 2002 was $32.20 million.
Liquidity is the ability to provide sufficient cash levels to meet financial
commitments and to fund loan demand and deposit withdrawals. The Company
maintains a significant level of liquidity in the form of cash and cash
equivalents ($24.99 million at September 30, 2003) and investment securities
available for sale ($110.85 million). Cash and cash equivalents are immediately
available for satisfaction of deposit withdrawals, customer credit needs, and
operations of the Company. The Company also maintains a significant amount of
available credit with both the Federal Home Loan Bank and several correspondent
financial institutions. Investment securities available for sale represent a
secondary level of liquidity available for conversion to liquid funds in the
event of extraordinary needs.
Forward-Looking Information
Certain information contained in this discussion may include "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended.
These forward-looking statements are generally identified by phrases such as
"the Company expects," "the Company believes" or words of similar import. These
statements speak only as of the date of this report. The statements are based on
current expectations, are inherently uncertain, are subject to risks, and should
be viewed with caution. Such forward-looking statements involve known and
unknown risks including, but not limited to, changes in general economic and
business conditions, interest rate fluctuations, competition within and from
outside the banking industry, new products and services in the banking industry,
risk inherent in making loans such as repayment risks and fluctuating collateral
values, problems with technology utilized by the Company, changing trends in
customer profiles and changes in laws and regulations applicable to the Company.
Although the Company believes that its expectations are based upon reliable
assumptions within the bounds of its knowledge of its business and operations,
there can be no assurance that actual results, performance or achievements of
the Company will not differ materially from any future results, performance or
achievements expressed or implied by such forward-looking statements.
16
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk (IRR) and Asset Liability Management
The Company's profitability is dependent to a large extent upon its net interest
income (NII), which is the difference between its interest income on
interest-bearing assets, such as loans and investments, and its interest expense
on interest-bearing liabilities, such as deposits and borrowings. The Company,
like other financial institutions, is subject to interest rate risk to the
degree that its interest-earning assets reprice differently than its
interest-bearing liabilities. The Company manages its mix of assets and
liabilities with the goals of limiting its exposure to interest rate risk,
ensuring adequate liquidity, and coordinating its sources and uses of funds.
Specific strategies for management of interest rate risk (IRR) on the lending
side of the balance sheet have included the use of ballooning fixed rate loans
and maintaining a significant level of 1, 3 and 5-year adjustable rate
mortgages. On the investment side, the Company maintains a significant portion
of its portfolio in adjustable rate securities. These strategies help to reduce
the average maturity of the Company's interest-earning assets.
The Company attempts to control its IRR exposure to protect net interest income
and net earnings from fluctuations in the general level of interest rates. To
measure its exposure to IRR, the Company performs monthly simulations of NII
using financial models that project NII through a range of possible interest
rate environments including rising, declining, flat and most likely rate
scenarios. The results of these simulations indicate the existence and severity
of IRR in each of those rate environments based upon the current balance sheet
position and assumptions as to changes in the volume and mix of interest-earning
assets and interest-bearing liabilities and management's estimate of yields
attainable in those future rate environments and rates which will be paid on
various deposit instruments and borrowings. The Company runs these rate shock
scenarios for 12 and 24 month projections out from the current month of the
model.
Over the past 24 months, management has made a concerted effort to shift a
portion of its short-term liablilities to longer-term maturities. This is being
done to help maintain a favorable interest spread once interest rates rise in
the future. The Company has been able to achieve this balance sheet
restructuring in several ways. Beginning in August 2001, the Company began
offering higher than market rates on its 24-month, 36-month, 48-month and
60-month certificates of deposit accounts and individual retirement accounts. By
doing this the Company was able to shift existing customers' time deposits, as
well as attracting new time deposit customers, to longer term maturities. The
Company has also seen significant increases in its 1-4 family mortgage lending.
The increase in this loan category has been primarily in adjustable rate
mortgages with one and three-year interest rate resets.
The earnings sensitivity measurements completed on a monthly basis indicate that
the performance criteria against which sensitivity is measured are currently
within the Company's defined policy limits. A more complete discussion of the
overall interest rate risk is included in the 2002 Form 10-K.
ITEM 4. Controls and Procedures
On an on-going basis, senior management monitors and reviews the internal
controls established for the various operating segments of the Bank.
Additionally, the Company has created a Disclosure Review Committee to review
not only internal controls but the information used by the Company's financial
officers to prepare the Company's periodic SEC filings and corresponding
financial statements. The Committee is comprised of the Senior Management Team
of the Bank and meets at least quarterly. Internal audits conducted by the
Company's internal audit department are also reviewed by senior officers to
assist them in assessing the adequacy of the Company's internal control
structure. These audits are also discussed in detail with the Company's Audit
Committee. The Company feels that sufficient internal controls and disclosure
controls have been established and have evaluated such controls as of the end of
the period covered by this report and believe them to be effective.
17
Furthermore, management asserts that there have not been any changes in the
Company's internal controls over financial reporting or in other factors during
the period covered by this report that have materially affected, or are
reasonably likely to materially affect, these controls or other factors.
18
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None.
Item 2. Changes in Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. (a) Exhibits
31.1 Rule 13a-14(a) Certification of Executive Vice President and
Chief Executive Officer
31.2 Rule 13a-14(a) Certification of Executive Vice President and
Cashier
31.3 Rule 13a-14(a) Certification of Chief Financial Officer
31.4 Rule 13a-14(a) Certification of Vice President of Accounting
32.1 Certification Statement of Executive Vice President and
Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
32.2 Certification Statement of Executive Vice President and
Cashier pursuant to 18 U.S.C. Section 1350.
32.3 Certification Statement of Chief Financial Officer pursuant
to 18 U.S.C. Section 1350.
32.4 Certification Statement of Vice President of Accounting
pursuant to 18 U.S.C. Section 1350.
(b) Reports on Form 8-K - None
19
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
HIGHLANDS BANKSHARES, INC.
(Registrant)
Date: November 13, 2003 /s/ Samuel L. Neese
----------------------------------------
Samuel L. Neese
Executive Vice President and
Chief Executive Officer
Date: November 13, 2003 /s/ James T. Riffe
----------------------------------------
James T. Riffe
Executive Vice President & Cashier
20
Exhibits Index
--------------
31.1 Rule 13a-14(a) Certification of Executive Vice President and Chief
Executive Officer
31.2 Rule 13a-14(a) Certification of Executive Vice President and Cashier
31.3 Rule 13a-14(a) Certification of Chief Financial Officer
31.4 Rule 13a-14(a) Certification of Vice President of Accounting
32.1 Certification Statement of Executive Vice President and Chief
Executive Officer pursuant to 18
U.S.C. Section 1350.
32.2 Certification Statement of Executive Vice President and Cashier
pursuant to 18 U.S.C. Section 1350.
32.3 Certification Statement of Chief Financial Officer pursuant to 18
U.S.C. Section 1350.
32.4 Certification Statement of Vice President of Accounting pursuant to
18 U.S.C. Section 1350.